Short Sale, Foreclosure, Bank-Owned: Pros, Cons, and the Bottom Line

Buying a short sale, foreclosure or bank-owned home can mean acquiring the home of your dreams at the price of your dreams. These sorts of properties are at different stages in the process of being repossessed by the lenders that originally financed the purchases, but they all offer the possibility of snapping up a desirable property at less than market value. Unfortunately, there are also some potential risks involved with purchasing these properties.

Here are the pros and cons of buying short sales, foreclosures and bank-owned homes, along with some ideas about how to manage the risks and maximize the potential rewards.

Short sales

Short sales, foreclosures and bank-owned properties correspond to steps in the process of a home going from being owned by the occupant to being repossessed and sold by the lender. In this process, short sales are at the first step, when the homeowner is getting behind on payments and in fact owes more than the house is worth — but the lender is not ready to try to take possession.

“A short sale is basically when the homeowner is upside-down in their mortgage,” explains Desari Jabbar, an agent who works with 70% more single-family homes than the average agent in Stone Mountain, Georgia. “They owe more than the property is worth.”

Owing more than the property is worth is what makes a short sale a short sale. If the property is worth more than what is owed, a homeowner who is having trouble making payments can simply sell the house and pay off the loan with the proceeds. But when the property is worth less than the balance on the loan, the solution to the problem is not quite so simple, and it becomes a short sale situation.

A major difference when buying a short sale is that the seller’s lender will have to agree to the deal. That’s not necessarily bad, because it takes the emotional component out of negotiating.

“Sometimes if you’re dealing with a seller who gets emotional, it can be difficult,” Jabbar says. “This is totally numbers.”

If you make the lender a reasonable offer that allows the bank to avoid foreclosure and cover whatever other costs it’s assumed, your offer has a good chance of being accepted.

While the seller and the bank are probably motivated to sell, the buyer needs to be able to justify the offer by showing it’s not too far off market value. But a short sale can be a good way to cut a good deal.

Short sale pros

One of the pluses of short sales is that it is often possible to buy a home before it goes on the market. “You might just know of someone that’s in distress,” Jabbar says. “Then you can go with the seller to the lender and try to get them to allow you to purchase the property for what the lender believes a fair market value is.”

Short sale homes are also often in better condition than homes that you’ll encounter later in the foreclosure process. Short sale owners are likely to be short on funds and unable to fund needed repairs. But because it’s still relatively early, the deferred maintenance may not have accumulated so much. And you can also have your short sale inspected before you close on the deal, so you know exactly what you’re getting yourself into, repair-wise.

Short sale cons

While getting a short sale under contract with the seller can be as quick as a normal purchase transaction, waiting for the lender to sign off on the deal can take some time, often months. “It’s a lengthier process than normal,” Jabbar says.

As part of the lender’s short sale authorization, the homeowner who is selling has to submit documents showing, among other things, that they are truly in financial hardship. “There’s a lot of paper to be considered by the lender,” Jabbar says. “They have to make sure they have their tax returns and any other documents the lenders might request.”

One potential stumbling block can crop up if the house appraises above the list price or offer price. If that happens, the buyer may be asked to pay more, up to the appraised value.

Also, if the inspection shows repairs are needed, the seller probably won’t have extra funds to pay for them. And repairs are likely to be necessary. “If the seller can’t pay their mortgage, they probably can’t take care of any maintenance,” Jabbar says. So as the buyer, you’ll have to determine how many repairs equals too much work for you.

Finally, while it’s great to identify a potential short sale before it goes on the market, you can’t buy a short sale from just anybody. “If you are a relative of the homeowner, you won’t be allowed to purchase the property,” Jabbar says. “It has to be an arms-length transaction.”

Short sale tips

To increase the chances your short sale purchase will go smoothly, talk to the seller about getting the short sale approved by the lender in advance. Then all you need to do is make the offer and line up financing.

Since the lender is also a part of a process that normally includes only two parties — buyer and seller — a little more effort will have to go into coordination. “The way to approach the short sale is to work hand-in-glove with the lender and seller,” Jabbar says.

The best advice if you want your short sale deal to work well is to work with an experienced agent. “A lot of agents just don’t get it,” Jabbar says.

“When you’re dealing with foreclosure, you have to really know what’s going on.”

Foreclosures

A foreclosed property is at the next step in the process of ownership reverting to the lender. “A foreclosure is when the homeowner has not been able to keep up with their mortgage payments, and unfortunately the bank has to take possession of the property,” Jabbar explains.

There is a step called pre-foreclosure, when the owner has gotten behind on their mortgage payments but the lender hasn’t begun foreclosure proceedings. At this point, the owner can catch up on payments and save their house. However, once the owner has received a notice of default from the lender, unless the payments are caught up, the property is on a road that can lead to foreclosure.

The major difference between short sales and foreclosures is that the lender is forcing the foreclosure sale, while a short sale is voluntary on the part of the seller. However, although the lender may be forcing the seller to relinquish ownership, the fact is that lenders don’t want to own real estate. So, they put the properties up for sale to try to recoup as much of their investment as they can.

Typically, foreclosed properties are sold at auctions, often held literally on the steps of the local county courthouse. Investors arrive at the auction, often held on the first Tuesday of the month, and make cash bids for properties presented for sale.

Foreclosure pros

Because lenders are focused on trying to cut their losses and turn unwanted properties into cash, foreclosures can be a great buying opportunity. Sometimes, although not always, the bank will accept the minimum reserve bid at auction (the minimum reserve is the lowest amount at which the lender is willing to accept bids — usually the outstanding amount owed on the mortgage). Because the auction bid generally starts at the amount that is owed on the mortgage, and not at the market value, a buyer at foreclosure auction is often able to get a home for less than market value.

Because your average homebuyer isn’t as interested in purchasing homes that are in foreclosure, there won’t be as much competition for the deal from the masses. There will likely be competition from investors, but because investors are focused solely on the dollars and cents of the investment, emotion isn’t as likely to drive up a selling price in a bidding war.

Foreclosure cons

One potential downside is that foreclosure sales are typically as-is. “You have to look at that house and decide if this is something you want to get,” Jabbar says. “Because most of the time the bank is not interested in doing any repairs.”

However, it can be difficult to get a look inside foreclosure properties. Buyers often have to bid on properties without even a walkthrough, much less a professional inspection.

Often, properties are still occupied by the former owners or tenants. Owners upset at the foreclosure may strip or vandalize property. “I had one that was foreclosed on that was a $400,000 house, and the next thing I know they had squatters in there,” Jabbar says. “Not only that, they did a quit-claim deed.” (This means that the owners transferred their ownership in the property without going through a traditional sale.) “It took two years for it to be resolved.”

A significant obstacle is the requirement that foreclosures purchased at auction be paid for immediately with a certified check. Financing a foreclosure, especially one purchased at auction, is unlikely.

Sometimes the former owner of the property will have a period of time — varying by jurisdiction — after the auction during which they can pay the lender what they owe and retain ownership. If that happens, the buyer’s deal to purchase the property is null and void.

Foreclosure tips

To succeed as a foreclosure buyer, do as much research on houses as you can before submitting bids. This may be limited to driving by and taking a look at the exterior, but any information you have is better than no information.

Learn how auctions work in your county before you bid. Ask an experienced auction-buyer, such as a licensed real estate agent, to tag along while you watch what they do. If you don’t feel comfortable you can do it, consider finding another way to buy a home.

Before you attend an auction intending to bid, make sure you’ve got your financing lined up. Bear in mind: You may need to present the auctioneer with a certified check for the full amount of the purchase. Other times, you may have a few days or even weeks to arrange financing. Know your local practices.

Bank-owned or REO homes

When a property has gone through the foreclosure process and not been sold at auction, it is referred to as a bank-owned or REO property. The lenders that own these properties are generally still anxious to unload them.

And, as is the case with short sales and auction purchases, you may be able to get an attractive deal on an REO house. But this process is friendlier to buyers than an auction.

REO pros

The process of finding and making an offer on a bank-owned property is much more familiar and comfortable than bidding at an auction or even negotiating a short sale. Bank-owned properties may be listed on popular real estate portals, including your local real estate association multiple listing service.

Buying a home from a bank is closer to the experience of buying a home from an individual owner. The difference is that the bank asset manager is primarily only concerned with getting as much return as possible as soon as possible. If you can make a good case that your offer is fair, based on comparable sales, you have a good chance of having it accepted.

Financial institutions, including the government home financing goliaths, have well-developed systems with online listings used to sell their REOs. Fannie Mae has HomePath and Freddie Mac has HomeSteps. The Department of Housing and Urban Development has HUDHomes.

You should be able to do a walk-through on an REO home before making a bid. The home will be unoccupied, since the bank has taken complete possession of it. Doing a walk-through reduces the chance you’ll be buying a home that needs major repairs.

Waiting can pay off here. If the home doesn’t sell quickly, the bank is likely to lower the price. “Every 25 to 30 days, they’ll do a price adjustment so it won’t sit on the market,” Jabbar says.

“They’re keen on getting these properties sold.”

Also, again unlike auctions, lenders selling directly are likely to give preference to first-time homeowners over investors. “They’re giving them first look at the properties,” Jabbar says. “Those are some great opportunities for buyers to purchase homes.”

REO cons

In keeping with the general theme of buying distressed and foreclosed properties, REO houses are sold as-is. Plus, they’ve been sitting vacant, sometimes for months or even years, so all kinds of problems, from vandalism to untended water leaks, could have wrought havoc on your future living space.

If REO homes are easy for you to find online, they’re also easy for others to find. That means there’s likely to be more competition for REOs than, say, a short sale that never even gets listed.

Because you negotiate with a bank asset manager rather than an individual homeowner, it’s all business. Sometimes buyers in competitive situations can convince a non-bank seller to accept their bid by making a personal appeal with, say, a letter describing what the home will mean to their family. But that won’t work with a bank. The higher-priced, better-financed offer will win almost every time with an REO.

Tips to make buying REO better

Getting your financing lined up with a preapproval letter is always a good idea before shopping for a home. With an REO, you might consider seeking a loan from the lender that owns the REO property. That could help speed things up and make your bid more attractive than competitors.

Document your offering price. Don’t just hit the bank with a low-ball offer. Present data on comparable sales showing why your offer considers the property’s fair-market value. That doesn’t mean you have to offer that much. An offer somewhat below fair market value should receive consideration if you have supporting evidence.

Because the property is sold as-is, getting an inspection may be even more important than with other sales. Bear in mind, the lender is unlikely to make any repairs, but you may be able to make a case for discounting the sale price to cover some fixes.

Don’t go it alone. Work with an agent who’s experienced in buying homes in this fashion. And, as is the case with all distressed, short sales, and foreclosures, be sure it’s an agent familiar with local laws and practices because they vary widely.

“I believe in having a qualified agent helping you through the process,” Jabbar says. “These are not easy if the agent doesn’t know the process.”

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